NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Torotel specializes in the custom design and manufacture of a wide variety of precision magnetic components, consisting of transformers, inductors, reactors, chokes and toroidal coils. Approximately 96% of Torotel’s sales are derived from domestic customers. The following summarizes the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements.

Principles of Consolidation

The consolidated financial statements include the accounts of Torotel, Inc. and its wholly-owned subsidiaries, Torotel Products, Inc., Electronika, Inc. and Subsidiary, and East Coast Holdings, Inc. (formerly named OPT Industries, Inc.). All significant inter-company accounts and transactions have been eliminated in consolidation.

Use of Estimates

In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Fair Value of Financial Instruments

Cost approximates market for all financial instruments as of April 30, 2004 and 2003.

Revenue Recognition

Revenue is recognized on contracts and orders in the period that the units are shipped (unit-of-delivery method). Both historically and currently, less than 5% of Torotel’s annual consolidated sales arise from contracts that are performed over a period of more than one year.

Inventories

Inventories are stated at the lower of cost or market. Cost is determined using a moving average cost method of valuation that currently and historically approximates the first-in, first-out method.

Property, Plant and Equipment

Property, plant and equipment are carried at cost. Depreciation and amortization are provided in amounts sufficient to relate the costs of depreciable assets to operations primarily using the straight-line method over estimated useful lives of three to five years for property and equipment, and ten to twenty years for buildings and improvements.

Cash Flows

For purposes of the statements of cash flows, Torotel considers all short-term investments purchased with maturity of three months or less to be cash equivalents.

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Employee Stock Option Plan

The employee stock option plan is accounted for under Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees , and related interpretations. This opinion requires that for options granted at less than fair market value, a compensation charge must be recognized for the difference between the exercise price and fair market value.

Intangible Assets

The intangible assets acquired in the purchase of Electronika are accounted for under Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible Assets . SFAS 142 requires that intangible assets be amortized over their useful life and tested for impairment annually.

Equity Investment in Apex

Torotel has a 16.47% interest in Apex. Since its inception, this investment was accounted for using the equity method because Torotel had the ability to exercise significant influence over Apex’s operating and financial activities (see Note N of Notes to Consolidated Financial Statements). As a result, Torotel’s investment in Apex, initially carried at cost, was adjusted quarterly for Torotel’s proportionate share of Apex’s earnings or losses. Because of Apex’s operating losses since inception, and the projected losses in the near term, Torotel recognized an impairment loss of $716,000 as of April 30, 2004. As a result, the estimated realizable value of Torotel’s investment in Apex is recognized at $150,000.

Advertising Costs

Advertising costs are expensed as incurred. Advertising costs were less than $1,000 for each of the years ended April 30, 2004 and 2003.

New Accounting Pronouncements

In April 2003, the Financial Accounting Standards Board (FASB) issued SFAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends SFAS 133, Accounting for Derivative Instruments and Hedging Activities , to address: (1) decisions reached by the Derivatives Implementation Group; (2) developments in other Board projects that address financial instruments; and (3) implementation issues related to the definition of a derivative. SFAS 149 has multiple effective date provisions depending on the nature of the amendment to SFAS 133. Torotel has not issued any such instruments and therefore the adoption of SFAS 149 did not have any effect on Torotel’s business, results of operations, and financial condition.

In May 2003, the FASB issued SFAS 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS 150 clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity, and requires that those instruments be classified as liabilities in statements of financial position. Previously, many of those financial instruments were classified as equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. On November 7, 2003, FASB Staff Position 150-3 was issued, which indefinitely deferred the effective date of SFAS 150 for certain mandatory redeemable non-controlling interests. Torotel has not issued any such instruments and therefore the adoption of SFAS 150 did not have any effect on Torotel’s business, results of operations, and financial condition

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Reclassifications

Certain reclassifications have been made to the previous years’ consolidated financial statements in order to conform to the presentations made in the current year.

NOTE B - INVENTORIES

The following table summarizes the components of inventories:

Raw materials		$	63,000
Work in process		231,000
Finished goods		33,000
		$	327,000

 

NOTE C - FINANCING AGREEMENTS

On March 31, 2004, Torotel Products entered into a $1,275,000 promissory note with Bank of Blue Valley. Under the terms of the note, the outstanding balance bears interest at a rate of 6.5% per annum. The note requires monthly principal and interest payments of $11,162. The note, which is guaranteed by Torotel, Inc. and Electronika, Inc., has a maturity date of March 25, 2007 and is collateralized by a first mortgage on the land and buildings in Grandview, Missouri and Olathe, Kansas. Proceeds of the loan were used to purchase and make improvements to the land and buildings in Olathe, Kansas, and to payoff the $325,000 balance on first mortgage loan on the Grandview property held by United Trust Bank. As of April 30, 2004, the outstanding balance was $1,270,000.

On March 31, 2004, Torotel Products also entered into a $200,000 revolving credit agreement with Bank of Blue Valley. Advances under the credit line are limited to 75% of eligible billed receivables. The revolving line is collateralized by the land and buildings in Grandview, Missouri and Olathe, Kansas. Under the terms of the agreement, the outstanding balance of the revolving line bears interest at 1.5% over the bank’s corporate base rate and has a maturity date of March 31, 2005. As of April 30, 2004, the effective borrowing rate was 5.5% and the entire credit line was available.

Information concerning Torotel’s long-term indebtedness is as follows:

Note payable to Bank of Blue Valley, maturing March 2007		$	1,270,000
Less: Current maturities		52,000
		$1,218,000

 

The amount of long-term debt maturing in each of the next five years is as follows:

Year Ending April 30,				Amount
2005				$	52,000
2006				56,000
2007				1,162,000
2008				—
2009				—
				$1,270,000

 

 

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NOTE D - NOTE PAYABLE TO SHAREHOLDERS

On March 28, 2002, Torotel entered into a $750,000 promissory note with the Caloyeras Family Partnership, whose members beneficially own and control 49% of the outstanding common shares of  Torotel. Under the terms of the note, the outstanding balance bears interest at a rate of 7% per annum and requires quarterly interest-only payments of $13,125. The note has a maturity date of March 28, 2007, and is collateralized by the common stock owned by Torotel in Apex and Electronika. As of April 30, 2004, the outstanding principal balance was $750,000. Proceeds from the loan were used to acquire an equity interest in Apex (see Note N of Notes to Consolidated Financial Statements).

NOTE E - INCOME TAXES

The provision for income taxes reflected in the consolidated statements of operations differs from the amounts computed at the federal statutory tax rates. The principal differences between the statutory income tax expense and the effective provision for income taxes are summarized as follows:

		2004			2003
Computed tax expense at statutory rates		$	225,000		$	241,000
Utilization of net operating loss carryforwards		(225,000		)	(241,000		)
Income tax expense (refund)		7,000			(8,000		)
(Increase) decrease in deferred tax assets		(64,000		)	35,000
Increase (decrease) in valuation allowance		64,000			(35,000		)
		$	7,000		$	(8,000	)

 

Torotel has available as benefits to reduce future income taxes, subject to applicable limitations, the following estimated net operating loss (“NOL”) carryforwards:

Year of Expiration				NOL Carryforward
2007					$	180,000
2009					495,000
2010					694,000
2011					319,000
2012					889,000
2013					801,000
2014					2,932,000
					$	6,310,000

 

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The difference between the financial and tax bases of assets and liabilities is determined annually. Deferred income taxes and liabilities are computed for those differences that have future tax consequences using the currently enacted tax laws and rates that apply to the periods in which they are expected to affect taxable income. Valuation allowances are established, if necessary, to reduce the deferred tax asset to the amount that will, more likely than not, be realized. Income tax expense is the current tax payable or refundable for the period plus or minus the net change in the deferred tax assets or liabilities. The following table summarizes the components of the net deferred tax asset:

Net operating loss carryforwards		$	1,768,000
Inventory valuation reserve		188,000
Depreciation and amortization		313,000
Disposal of ECH liabilities		137,000
Tax credit carryforwards		19,000
Other		18,000
		2,443,000
Less valuation allowance		2,443,000
		$	—

 

NOTE F - COMMITMENTS AND CONTINGENCIES

Torotel is a party to eight operating leases used in the performance of its business. All eight leases are non-cancelable. As of April 30, 2004, there were no capital lease obligations. Future minimum lease payments are as follows:

Year Ending April 30,				Operating Leases
2005				$	48,000
2006				40,000
2007				30,000
2008				10,000
2009				—
				$	128,000

 

Total rent expense for all operating leases for the years ended April 30, 2004 and 2003, including an expired real estate lease, was $87,000 and $83,000, respectively.

NOTE G - EMPLOYEE INCENTIVE PLANS

Incentive Compensation Plan

Torotel’s shareholders approved the Incentive Compensation Plan (the “Plan”) in 1994. All key employees are eligible to participate in the Plan. The Plan provides for participants to receive incentive payments in cash and/or Torotel common stock based on targeted pretax earnings, as defined in the Plan. There were no awards under the Plan for the year ended April 30, 2004. Awards under the Plan for the year ended April 30, 2003 were $11,000.

Employee Stock Option Plans

In accordance with the Incentive Compensation Plan approved on September 19, 1994, Torotel reserved 400,000 common shares for issuance to key employees pursuant to the exercise of incentive and non-qualified stock options granted prior to June 20, 2004. The options are accounted for under APB Opinion 25, Accounting for Stock Issued to Employees , and related interpretations in accounting for this

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Plan. The incentive stock options have a term of five years when issued and vest 50% per year during the first two years. The non-qualified stock options have a term of ten years when issued and vest 25% per year during the first four years. The exercise price of each option equals the market price of Torotel’s common stock on the date of grant. Accordingly, no compensation cost has been recognized for the Plan. Had compensation cost for the Plan been determined based on the fair value of the options at the grant dates consistent with the method of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, Torotel’s operating results would have been reduced to the pro forma amounts indicated below.

				2004			2003
Net loss		As Reported		$	(1,439,000	)	$	(170,000	)
		Pro Forma		$	(1,443,000	)	$	(177,000	)
Basic and diluted loss per share		As Reported		$	(.28	)	$	(.03	)
		Pro Forma		$	(.28	)	$	(.03	)

 

The fair values of the options granted were estimated on the date of grant using the Black-Scholes options-pricing model. The fair value of the incentive stock options was determined using the following weighted average assumptions: no dividend payments over the life of the options; expected volatility of 551.0%; risk-free interest rate of 3.50%; and expected life of five years.

Stock option transactions under this Plan for each period are summarized as follows:

		2004									2003
						Weighted							Weighted
		Shares				Average					Shares		Average
		Under				Exercise					Under		Exercise
		Option				Price					Option		Price
Outstanding at beginning of year			40,000				$	.37			40,000			$	.37
Granted			—				—				—			—
Exercised			—				—				—			—
Forfeited			—				—				—			—
Outstanding at end of year			40,000				$	.37			40,000			$	.37
Options exercisable at end of period			40,000				$	.37			20,000			$	.37
Weighted average fair value of options granted during the year							—							—

 

The following information applies to options outstanding at April 30, 2004:

Number outstanding		40,000
Range of exercise prices		$	.37
Weighted average exercise price		$	.37
Weighted average remaining contractual life		2.50 yrs.

 

Employee Stock Purchase Plan

Torotel has an Employee Stock Purchase Plan that allows employees to purchase Torotel common stock at a formula price that approximates market value. The Plan enables employees to purchase stock through payroll deductions of up to 10% of their compensation. Torotel matches one-half of the employee’s contribution. Stock purchased under the Plan is restricted from transfer for one year after the date of issuance. There were no expenses under the Plan during the years ended April 30, 2004 and 2003.

 

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401(k) Retirement Plan

Torotel has a 401(k) Retirement Plan for Torotel Products’ employees. Employer contributions to the Plan are at the discretion of the Board of Directors. Employer contributions to the Plan were $5,000 and $4,000 for the years ended April 30, 2004 and 2003, respectively.

NOTE H - EARNINGS PER SHARE

Statement of Financial Accounting Standards (SFAS) 128, Earnings per Share , requires dual presentation of basic and diluted EPS on the face of the statement of earnings regardless of whether basic and diluted EPS are the same; and requires a reconciliation of the numerator and denominator used in computing basic and diluted EPS. Basic EPS excludes dilution and is computed by dividing earnings available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Pursuant to SFAS 128, the basic and diluted earnings per common share were computed as follows:

		2004			2003
Net loss		$	(1,439,000	)	$	(170,000	)
Weighted average common shares outstanding		5,111,590			5,111,590
Incremental shares		—			—
Basic and diluted loss per share		$	(.28	)	$	(.03	)

 

No incremental shares are included in the EPS calculations due to the net loss incurred in both years.

NOTE I - STOCK WARRANTS

A warrant certificate issued in May 1998 to purchase 100,000 shares of Torotel, Inc. common stock at 75 cents per share expired on May 4, 2003. Stock warrant transactions for each period are summarized as follows:

		2004							2003
		Shares Under Warrant		Weighted Average Exercise Price					Shares Under Warrant		Weighted Average Exercise Price
Outstanding at beginning of year		100,000			$	.75			100,000			$	.75
Granted		—			—				—			—
Exercised		—			—				—			—
Forfeited		(100,000	)		$	.75			—			—
Outstanding at end of year		—			—				100,000			$	.75
Warrants exercisable at year-end		—			—				—			—
Weighted average fair value of warrants granted during the year					—							—

 

NOTE J - ACCRUED LIABILITIES

Accrued liabilities consist of the following:

Employee related expenses		$	99,000
Other, including interest		19,000
		$	118,000

 

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NOTE K - GAIN ON SETTLEMENT OF DEBT

Other income as presented in the accompanying consolidated statements of operations for the year ended April 30, 2004, includes a gain of $440,000 resulting from Torotel being legally released from being the primary obligor for the liabilites of East Coast Holdings, Inc. (ECH), a wholly-owned subsidiary of Torotel, which was dissolved in 2004.

Other income as presented in the accompanying consolidated statements of operations for the year ended April 30, 2003, includes a gain of $75,000 resulting from the settlement of an old liability at an amount lower than originally recorded.

NOTE L - INFORMATION ABOUT MAJOR CUSTOMERS

For the year ended April 30, 2004, sales to two major customers accounted for 18% and 12% of consolidated net sales. For the year ended April 30, 2003, sales to two major customers accounted for 12% and 10% of consolidated net sales.

NOTE M - IMPAIRMENT AND  AMORTIZATION OF INTANGIBLE ASSETS

Since the acquisition of Electronika primarily involved the purchase of certain technology-based intangible assets, annual reviews have been performed to determine the amount of any impairment loss.

As a result, Torotel recognized an impairment loss of $610,000 and $219,000 in the third quarter of the fiscal years ended 2004 and 2003, respectively. Since Electronika’s sales have continued to decline, and in the opinion of Torotel management will most likely continue in a downward trend, an additional impairment loss of $200,000 was recognized in the fourth quarter of fiscal 2004. The remaining carrying value of these intangible assets is estimated at $861,000 and is supported by the projected amount recoverable from the selling shareholders of Electronika (the Caloyeras Family Partnership). The selling shareholders contractually guaranteed that the aggregate sales from Electronika’s existing ballast designs over the first five (5) full fiscal years, specifically fiscal years 2003-2007, would be at least $2,500,000, which based on the terms of the Manufacturing Agreement with Magnetika, Inc., would result in an aggregate gross profit of $1,500,000 before any operating expenses. Aggregate sales in the first two full fiscal years were $915,000.

The total intangible amortization expense for the years ended April 30, 2004 and 2003, was $153,000 and $339,000, respectively. The following table provides the adjusted gross carrying value and accumulated amortization for each major class of intangible asset based on Torotel’s reassessment of previously recognized intangible assets in accordance with the adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets :

						2004								2003
		Average Amortizable Life				Gross Carrying Amount			Accumulated Amortization					Gross Carrying Amount			Accumulated Amortization
Order backlog			1			$	205,000			$	205,000			$	205,000			$	205,000
Aircraft			3			1,148,000				287,000				1,958,000				134,000
						$	1,353,000			$	492,000			$	2,163,000			$	339,000

 

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The total intangible amortization expense for the years ended April 30, 2004 and 2003, was $153,000 and $339,000, respectively. The estimated aggregate amortization expense for each of the next five years is as follows:

Year Ending April 30,				Amount
2005				$	33,000
2006				—
2007				—
2008				—
2009				—
				$33,000

 

NOTE N - EQUITY INVESTMENT

On March 29, 2002, Torotel acquired a 17.8% equity interest in Apex. The total investment of $1,035,000 consisted of $35,000 in acquisition costs and a stock purchase of 4,000,000 common shares for $1,000,000, of which $250,000 came from available cash and the remaining $750,000 from loan proceeds from the Caloyeras Family Partnership (see Note D of Notes to Consolidated Financial Statements). The Caloyeras Family Partnership and a Caloyeras Trust also acquired 4,000,000 shares of Apex on the same terms as Torotel. On May 23, 2003, Torotel purchased an additional 355,637 common shares of Apex stock for $89,000 at 25 cents per share. As of April 30, 2004, Torotel now owns a 16.47% equity interest in Apex.

This investment is accounted for using the equity method because Torotel has the ability to exercise significant influence over Apex’s operating and financial activities. As a result, Torotel’s investment in Apex, which was initially carried at cost, is adjusted quarterly for Torotel’s proportionate share of Apex’s earnings or losses. Because of Apex’s operating losses since inception, and the projected losses in the near term, Torotel recognized an impairment loss of $745,000 as of April 30, 2004. As a result, the estimated realizable value of Torotel’s investment in Apex is recognized at $150,000.

The accompanying consolidated statements of operations include a loss of $170,000 for the fiscal year ended April 30, 2004, resulting from Apex’s unaudited operating results for the fiscal year ended February 29, 2004. Condensed financial statements for Torotel’s investment in Apex are as follows:

Condensed Balance Sheet

		2004
Current assets		$	657,000
Other assets		7,388,000
		$	8,045,000
Current liabilities		$	1,035,000
Other liabilities		4,141,000
Stockholders’ equity		2,869,000
		$	8,045,000

 

Condensed Statements of Operations

		Fiscal Year Ended_
		2004			2003
Net sales		$	4,542,000		$	5,329,000
Gross profit		$	1,850,000		$	2,049,000
Net loss		$	(1,033,000	)	$	(334,000	)

 

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